Hult International Business School - London

Accounting for Managers

Handout 7 – Corporate Governance

Fall 2023

-1-
Managers’ Interaction – Theory (Anglo-
Saxon Context)
Shareholders Lenders
Maximize Hire & Fire
Shareholder Managers
• Proper Protect
Value Bondholders Lend Funds
•Always Act in Governance
•Boards Interests
Shareholders
Best Interests •ASM

Corporate Managers

Rationally, Disclose
Efficiently Corporate
Asses Value Information
Impact Truly & Timely

Financial Markets

2
Managers’ Interaction – Reality (Anglo-
Saxon Context)
1. Shareholders 2. Lenders

Have Little or Lenders /

Put Managers’ No Power Over Lend Funds
Own Interests Bondholders
Management Do Get
First
“Ripped Off”

Corporate Managers
Manipulate
With Timing of
Markets Often Disclosure or
Are Irrational In Disclose
Their Misleading
Assessment . Information

3. Financial Markets

3
1. Shareholders’ vs. Managers’ Interests

Theory
• Exercise full control over management by means of:
• Board of Directors
• Annual General Meeting
Reality
• Fundamental problems exist with both “levers” of
corporate governance and in many instances managers
put their interests ahead of those of shareholders’.

4
Annual General Meeting

Three factors dilute the power of shareholders at AGM:

1. Majority of small shareholders do not go to AGMs (cost issue).

2. Incumbent management benefits from unreturned proxies.

• In the US, approximately 60% of proxies do not get returned.
• (In most public companies) proxies that are not voted (returned) count as
votes for incumbent management.

3. Institutional investors, in most cases, sell (their shareholdings) if not

satisfied with the management.
• For funds (which on average hold hundreds of stocks) fighting management
is time consuming and costly.
• In large public companies, 70% and above of shares are held by institutional
investors.

5
Board of Directors (I)
Corporate governance varies between countries, especially
regarding the board system.
There are countries that have a one-tier board system (like the U.S.)
and there are others that have a two-tier board system like Germany.
Common law countries (Anglo-Saxon) Civil law countries (Asia, Continental Europe)

In a one-tier board, all the directors (both In a two-tier board there is an

executive directors as well as non-
executive directors) form one board,
called the board of directors.
• Under this model the board of directors is
composed of both executive and non-executive
directors, the latter being meant to supervise
the former's management of the company.
executive/managing board (all
executive directors) and a separate
supervisory board (all non-executive
directors).
• Under this model directors’ roles are a little bit
more obvious.

The debate about which system leads to better corporate governance is ongoing.
Improvements in corporate governance are often the result of shareholders (such as “activist”
private investors or funds) holding boards (whether one- or two-tier) of companies in which
6
they invest to account.
Board of Directors (II)
Although in recent years the situation has improved
substantially, remnants of the old era are still visible:
• In many instances, CEO either picks or recommends directors.
• Directors hold only “few” shares in “their” companies.
• In many instances directors are CEOs of other companies; and cross
“boardship” between CEOs of companies.

7
How to Identify “the Worst Board Ever” ?
Common sense questions below help identify the “quality” of
the BoD.
• How many people of the Board ? (17)
• How far do they live from the headquarters ?
• How many insiders on the Board ? (8)
• Do they attend BoD meetings regularly ? (Some do)
• Is the CEO the Chairman of the Board ? (Yes)
• Are the non-insiders, real non-insiders ? (Some are)
• Is CEOs personal lawyer on the Board ? (Yes)

Calpers, the California Employees Pension Fund (one of the first activist
shareholders), came up with a three part test to assess whether the Board is
“somewhat” functional (1997)
• Are a majority of the directors outside directors ?
• Is the chairman of the board an outsider (and not the CEO) ?
• Compensation and audit committees; are they composed entirely of
outsiders?

Disney was the only S&P 500 company to fail the test on all thee questions.
• In 1997, Business Week voted Disney’s board “the worst board ever”. 8
 Overpaying for Acquisitions
By far ... the quickest and most “efficient” way to destroy shareholders’
wealth.
• In 50% to 55% of acquisitions, acquirer’s stock price goes down.
• It has been shown that stock price change on the
announcement day is the best predictor of whether the
acquisition will be a “success”.
• Many studies show that after 5 – 10 years, at least 60% of
acquisitions do not work (combined company is less profitable than
the two separate companies prior to the merger).
• Large number of mergers (nearly 50%) that are reversed few years
later ... a clear admission that merger did not work.
• Factors driving the acquisition perhaps had nothing to do with
increasing shareholder wealth.
• 1990’s KPMG study showing that in 15-20% of mergers there
actually were synergies.
• Lexis/Nexis test (on the size of CEO’s ego) to predict the acquisition
premium.
-9-
2. Shareholders’ vs. Lenders’ Interests
Theory
• Both types of investors can be properly served/protected by
managers and there is no conflict of interest between the two.
Reality
• Fundamentally different (and often incompatible) types of
investors, with vastly different risk profiles.
• Having invested in a company ... they certainly are not “in the
same boat”.
• Lenders are (generally):
• more risk averse;
• accept lower returns in exchange for a higher level of downside
protection.
• Shareholders are (generally):
• Less risk averse;
• demand higher returns in exchange for a higher level of downside
10
risk.
Practical Ways of Altering the Balance
There exist plenty of ways that managers can alter the balance
between shareholders and lenders:
• Altering Dividend Policy: Significantly altering the dividend policy (or
paying out special dividends) increases lenders’ risk, thus hurts their
investment; shareholders are the benefactors.
• Changing Investment Profile Towards More Risky Projects: It alters
the risk profile of lender’s investment (whose compensation now
seems inadequate relative to that negotiated at the time of lending).
Again, lenders’ interests are hurt and benefactors are shareholders
who favour the management taking on riskier projects with lenders’
money.
• Increasing Borrowings: Existing lenders are all worse off if the
company borrows more than what was agreed before.

11
3. Shareholders’ vs. Financial Markets

Theory
• Managers disclose information truly and on time.
• Financial markets efficiently assess impact on value, which
implies that:
• good (long term) projects get rewarded,
• Short term accounting manipulations will be seem through by the
market;
• Stock price always reflects performance.
Reality
• Managers “manage” both ... the information itself and the way
it is disclosed.
• Financial markets are often irrational in their assessment of
information, over-reactions/mistakes do occur frequently.
12
Practical Ways of Managing the Information
Flow
Ways of managing the information flow:
• Negative information is often delayed (or suppressed altogether).
• Virtually all negative information is disclosed on Fridays after market
has closed.
• Often bad information is “mixed” with good news.
• Sometimes intentionally misleading (fraudulent) information is
disclosed.

13
Murphy's Law – What can go wrong, often
does.
1. Shareholders 2. Lenders

Have Little or Lenders /

Put Managers’ No Power Over Lend Funds
Own Interests Bondholders
Management Do Get
First
“Ripped Off”

Corporate Managers
Manipulate
With Timing of
Markets Often Disclosure or
Are Irrational In Disclose
Their Misleading
Assessment . Information

3. Financial Markets

14
Brief History of Corporate Governance (I)
More has happened in the space of shareholder activism in
the past 10 years than in the previous 100 years.
Early 1900’s – 1940’s 1950’s – 1970’s

• Most big companies owned • Emergence of mutual funds

and run by families
• Fords, Carnegies, Vanderbilts,
Mellons, Reckefellers, etc.
• Not widely held, with huge
majority shareholders.
• Very much like in today’s
emerging markets, China, India
• First securities regulations post
1928 crash.
• Disclosure of information,
• In 1943 shareholder proposals
allowed for the first time.
• Change of leadership in
several of “old guard” family
businesses in favor of
“professional managers”.
• Partial exits/sales of shares,
companies more widely held.
• Evelyn Davis as the first
shareholder activist;
• Institutional Investors start
coming together.
• Council of Institutional Investors
15
 Brief History of Corporate Governance (II)
More has happened in the space of shareholder activism in
the past 10 years than in the previous 100 years.
1980’s – 1990’s 2000’s – Present

• Era of conglomerates and of • Post .com bust followed by

“corporate raiders” who try to break
them up.
• Poison pill invented to protect managers;
“we know best, our shareholders are to
be seen, not heard”;
• Junk bond market invented to allow
corporate takeovers;
• Beginning of professional
shareholder advisory industry.
• ISS formed in 1985.
• Pension funds start putting proposals on
ballots.
corporate scandals …
incredible change to the
landscape;
• Sarbanes – Oxley act;
• New SEC and Stock
Exchange rules stimulating the
change in shareholder rights;
• Vote “no” campaign at Disney;
• Glass Lewis came on the scene.
• Nelson Peltz and Heinz proxy
contest.
16
What Is Changing – Board of Directors
Over time BoDs have become smaller:
• On average 15 – 20 in 1970’s → 10 – 12 in early 00’s.

Over time BoDs have decreased the number of insiders:

• On average 5+ in 1970’s → 2 in early 00’s.

Over time BoDs have increased stock based compensation,

less cash:
• On average 4% in stock in 1970’s → approximately 75 – 80% in
early 00’s.

Over time BoDs selection driven by a nominating committee,

fewer CEO appointees:
• On average 5% of BoD members identified by a committee in
1970’s → approximately 75% in early 00’s.
-17-
What Is Changing – Protection Mechanisms

Over time % of companies with Poison Pills in force has

decreased:
• On average 60% in 2002 → 35% in 2007 → 10% in 2011.

Over time % of companies with “Staggered Boards” has

decreased:
• On average 60% in 2002 → 40% in 2007 → 20% in 2011.

-18-
What Is Changing – Management Attitude

Management Attitude:
• From “Old School” (small companies, rarely present in
media;
• “If you don’t like it, just sell your shares …”
• To “New School” (large companies, under significant
public scrutiny)
• Know your shareholders; reach out to shareholders;
• Well advised;
• Sensitive to proxy advisors;

-19-
What Is Changing – Regulations (I)

“Say on Pay”
• Introduced as a new provision of the Dodd–Frank Wall Street
Reform and Consumer Protection Act (2007 – 2010) gives
shareholders a non-binding vote on executive compensation;
• Originally applicable to companies with outstanding funds from the
TARP (Troubled Asset Relief Program);
• Also, now contains a provision for a shareholder vote on “golden
parachutes”;
• In the United Kingdom shareholders were allowed a non-binding, or
advisory vote on pay as part of the Companies Act 2006 reform
mandating a vote on director pay at the yearly accounts meeting.

In 2012, less than 3% of US companies which voted on “say

on pay” measures failed to pass them.

-20-
What Is Changing – Regulations (II)

“Shareholder Access to a Proxy”

• No longer do shareholders have to go through a lengthy and costly
process of preparing their own proxy ballot;
• Regulations now allow shareholders access to company sponsored
proxies on which they can put their own proposals they want to
submit for a vote.
• This as a result of a 2011 court ruling that upheld shareholders’ ability to submit
shareholder proposals requesting that companies allow investors access to the
proxy, investors began to adopt various approaches to ensure this important right.

-21-